Thursday, June 18, 2015

The prevailing inflation meme is that it is dangerously low, and for years central banks have been trying very hard—without much success—to get it to rise. The reality—at least in the U.S.—is that the underlying "core" rate of consumer inflation has been running at close to 2% for over a decade. Energy prices have been the principal cause of variations from this trend.

Here are some charts to prove the point:

The "core" rate of CPI inflation has been far less volatile than the total rate of CPI inflation. The first of the above two charts show the year over year change in the CPI and the CPI Core indices. The second focuses on the 6-mo. annualized change in these same indices. The total rate of CPI inflation was about zero over the past six months, but it grew at a much more rapid 3.18% (annualized) rate over the past three months. In other words, the overall CPI is quickly "catching up" to the CPI Core and CPI ex-energy rate of inflation, and all are covering at something in the range of 1.8-2.0%.

The chart above shows the 10-yr annualized change in the Core CPI. By this measure, the Core CPI has been running very close to 2%, on average, for the past 14 years.

The CPI ex-energy has also been running very close to 2%, on average, for the past 12 years, as the charts above show. Over the past 10 years, the annualized rate of inflation by this measure has been 1.99%. Over the past year, it was 1.71%.

This last chart looks at the long-term trends of the CPI ex-energy. In the past decade it has been relatively low and stable, much as it was in the first half of the 1960s.

As the chart above shows, inflation as measured by the CPI and the PCE deflator has been almost the same. Over the past 20 and 30 years, inflation according to the CPI has tended to register about 40-50 bps higher per year than the PCE deflator. Thus, if the CPI continues to run at just under 2%, the PCE deflator (and its core version) will very likely run about 1.5% per year. There is nothing scary or worrisome about either of those numbers.

UPDATE: The bond market is currently priced to this same conclusion: consumer price inflation is very likely to be just under 2% for the foreseeable future.

The bond market currently is priced to the expectation that the CPI will average 1.72% over the next 5 years.

The prices of 10-yr TIPS and 10-yr Treasuries reveals that the market expects the CPI to average 1.91% over the next 10 years.

7 comments:

What if the Fed had been more stimulative? Would the rate of inflation be any higher? Or, would we have experienced more real growth?

And it should be noted that the Fed targets 2% inflation on the PCE and has been about 50 basis points below that target on and off for the last several years.

The issue is somewhat clouded by the fact that measuring inflation may be more alchemy and science.

Many right-wingers have pointed out that increases in product quality are not captured.

I have questions on whether housing is properly measured, since many people invest in housing as much as they consume housing. This issue is further clouded by the fact that so many local governments such as the City of Newport Beach criminalize the construction of new housing.

All in all, I think the Fed needs to concentrate on promoting robust growth and less on "fighting inflation."

Benjamin: doesn't it strike you as curious that core inflation has been averaging almost 2% for the past 14 years, during which time the Fed has been easy (early- to mid-00s), very tight (2007-2008) and extremely easy (2009-present)? And that economic growth has been sub-par (averaging 1.8% per year) throughout? Monetary policy has been all over the map, yet core inflation has been rather low and relatively stable, while economic growth has been decidedly disappointing.

This suggests to me that the Fed's ability to fine-tune inflation is at best suspect, and its ability to stimulate growth is at best quite modest. You have yet to answer this question: how is it that easy money can stimulate growth, when growth only occurs when the economy produces more with a given amount of inputs (i.e., when productivity rises), and productivity rises only as a result of more risk-taking, more investment, and more work? Very low and even negative interest rates may make borrowing more attractive to some, but does that borrowing lead to a more productive economy? And what about savers: do they save more when interest rates are very low or negative? Artificially low interest rates may stimulate borrowing, but they may also discourage lending and risk taking. The path from easy or even super-easy money to stronger growth is not at all obvious to me.

the fed and its manipulations are no substitute for sound federal government policy. lower taxes and regulation cannot be trumped by zero interest rates. obviously, the US lacks the former and thus sub par growth. you don't need to be an economist to see the obvious.

I've been doing some work separating shelter inflation from core inflation. Constrictions on housing supply in the major metro areas are creating supply-based shelter inflation. For the past 20 years, shelter inflation has typically been 3% and core minus shelter inflation has been closer to 1%. That's basically where they are running now. It's tough for wage growth to remain positive with health inflation capturing a lot of the 1% that's left.

I would say that Fed policy has been tight for most of those 20 years (meaning below target inflation, when we account for the housing supply problem), and was very tight in the 2006-2008 period. From 2003-2005, core and shelter inflation began to converge at 2%, suggesting roughly neutral monetary policy, compared to the stated target, but the housing supply problem meant that home prices rose during that period, and the country flipped out.

Until we allow more building in the major cities, it will be impossible for the Fed to actually achieve sustainably neutral monetary policy.

I disagree that the Fed has been "easy" since 2009---Scott Sumner would disagree with you also. And probably Milton Friedman. After all, in 1992 Friedman chastised the Fed for being "too tight" when inflation was at 3% and real growth about the same. Friedman also the Fed was too tight in 1956-7, and the Great Depression, and he thought the Bank of Japan was too tight.

If you think the Fed has been "easy," since 2009 then you can say the same for the Bank of Japan 1992 to 2012, when Japan had zero interest rates, but sustained minor deflation and a rising yen. The BoJ was so easy they had deflation.

The fact that the Fed is at zero does not mean the Fed has been easy! It could be that interest rates "should" be at negative 2 percent. But that is impossible.

The Fed probably should have kept on with QE, which seemed to be having positive results. Certainly, the Fed is still below its target (which is not supposed to be a ceiling) of 2% on the PCE deflator. So, by its own charter, the Fed has been too "tight" since 2009.

The market says the Fed has been too tight, if it really believe that the CPI will under 2% for the next 10 years. The CPI runs about 40 basis points above the PCE deflator. So the market is aging the Fed will undershoot its target for the next 10 years.

Anyway, my real point is that monetary policy has to be made with the structural impediments and imperfections that exist in the real world---the central banks are pompous if they think they can issue edicts that economies clean up their act and that the money supply is sufficient.

When, oh when, will the City of Newport Beach decriminalize new housing construction? That is a structural impediment (widely copied), and in a democracy we have to live with it--as we do with the VA, the USDA, food stamps, or Fannie and Freddie.

The road to greater supply is paved with inflation. I wish it were different, but utopia will have to wait.